Basket Default Swaps

M. Konikov, M. Marinescu, and H. Stein

Bloomberg LP
August 9, 2004

Contents
1 Introduction 2

2 Pricing basket default swaps 3

3 Copula models 5
3.1 Gaussian copula . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.2 Clayton copula . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3.3 Tail dependencies in the copula models . . . . . . . . . . . . . 8

4 Implied marginal distribution of time to default 9

5 BDS sensitivity measures 9

6 Discussions 10

1
1 Introduction
A basket default swap (BDS) is a default protection instrument written on
a basket of m bonds. The buyer of the protection pays a specified rate
on a specified notional principal until the n-th (n ≤ m) bond in the basket
defaults or the contract expires. If the n-th default occurs before the contract
expiration, the buyer is entitled either to exchange the bond issued by the
n-th defaulted entity for its face value N or to receive a cash equivalent
payment given by
(1 − Rn )N, (1)
where Rn is the corresponding recovery rate.1
In general, a BDS contract is characterized by: an underlying basket of m
bonds (e.g. 5), a number of defaults that triggers the default payment (e.g.
2), the maturity of the deal (e.g. 5 years), the coupon frequency (e.g. quar-
terly), the notional principal (e.g. $10M), and the spread or coupon payment
(e.g. 100bps). In addition, one must supply information about: the actual
coupon schedule (e.g. first/last coupon dates, the date generation method),
the day count convention (e.g. ACT/360), the business day calendar, and
the payment dates offsets. We assume that the recovery rates are known
quantities supplied by the user (e.g. 0.4, 0.35, 0.2, 0.8, 0.4).2
The pricing methodology presented in this paper is based on the one-
factor mixture joint distribution model, proposed by Gregory and Laurent
[1], Schonbucher [2], Hull and White [3], and Konikov, Madan, and Marinescu
[4]. For a general description please see [5] and [6]. This is a non-Monte-
Carlo method based on the assumption that each element of the basket is
coupled to a common single stochastic process and the joint distribution of
default times is constructed from the corresponding marginal distributions
via a copula.
The CDSN Bloomberg function implements two copula models: Gaus-
sian and Clayton. The implied marginal distributions of default times are
parameterized by a piecewise exponential function. The piecewise exponen-
tial coefficients are calibrated to the credit default swap (CDS) spreads of
different maturities.
1
We consider all the bond notionals in the basket to be equal to N
2
In general the recovery rates are known only when the default event is officially
recorded, and its value may depend on many economic factors. To express this mar-
ket reality, one can model the recovery rates as random variables. However, in this paper
we follow the common practice of assuming deterministic recovery rates.

2
2 Pricing basket default swaps
As already mentioned, under the one-factor mixture joint distribution model,
each element of the basket is coupled to a single common stochastic process
V called, for the purpose of this presentation, the market process. A direct
consequence of this assumption is that conditional on a given market state,
the probabilities of default for each entity in the basket are independent, and
so the BDS evaluation problem becomes quasi-analytic.
The BDS floating leg consists of a single payment of (1 − Rk )N in the
event that the n-th default in the basket is produced by the bond belonging
to the k-th entity, as in Eq. (1). We denote the present value of the floating
leg by F LT .
In contrast, the fixed leg of a BDS contract consists of a succession of
regular coupon payments and an accrued payment if the n-th entity defaults.
The present value of the fixed leg is proportional to the BDS spread, s (the
coupon rate). Let F IX denote the present value of the fixed leg for a unit
BDS spread. Then, for any given BDS spread value s, the present value of
the fixed leg is given by s × F IX. Let CP and ACC be the coupons and
accrued contributions to the F IX, respectively. Then we can write,
F IX = CP + ACC. (2)
With these notations, the BDS price (present value) is given formally by
P V = F LT − s × F IX. (3)
A BDS is said to be priced at par if its price is zero. In this case the BDS
spread is called the BDS par-spread. The BDS par-spread is given formally
by
F LT
spar = . (4)
F IX
Under the one factor mixture model one can rewrite the coupons, accrued,
and floating leg contributions as
Z
CP = φ(v)CP(v)dv, (5)
Dv
Z
ACC = φ(v)ACC(v)dv, (6)
Dv
Z
F LT = φ(v)FLT (v)dv, (7)
Dv

3
where CP(v), ACC(v), and FLT (v) are the coupons, accrued, and floating
leg contributions conditional on a given market state v, respectively, and φ(v)
is the probability density function of the market states. The integral is over
the domain of possible values of v, i.e. Dv .
For convenience, we assume a unit basket notional. We denote by qin−1,m−1 (t, v)
the conditional probability density of the event that n − 1 obligors, not in-
cluding the i-th one, have defaulted prior to time t, and the i-th obligor
defaults at time t. And by S n,m (t, v) we denote the conditional probability
that less than n obligors have defaulted up to time t. S n,m (t, v) is called
the basket survival function. Let Np be the number of coupon payments,
D(t) the risk-free discount factor at time t, ∆i the year fraction between two
coupon dates Ti−1 and Ti , and ∆t the year fraction between time t and the
last coupon date before t. Then, we can write
Np
X
CP(v) = ∆i D(Ti )S n,m (Ti , v), (8)
i=1
Xn Z Tn
FLT (v) = (1 − Ri ) D(t)qin−1,m−1 (t, v)dt, (9)
i=1 T0
n Z
X Tn
ACC(v) = ∆t D(t)qin−1,m−1 (t, v)dt. (10)
i=1 T0

Since we assumed conditional independence of times to default, we can write

X n−1
Y m−1
Y
qin−1,m−1 (t, v) = pi (t, v) Fjk (t, v) Sjk (t, v), (11)
(j1 ,...,jm−1 ) k=1 k=n

where (j1 , . . . , jm−1 ) is any permutation of (1, . . . , m)\{i}, Fj (t, v) is the con-
ditional cumulative distribution of time to default for the j-th obligor, Sj (t, v)
is its survival function, and pj (t, v) is its conditional probability density of
default. Similarly, we can write
n−1
X i
X Y m
Y
n,m
S (t, v) = Fjk (t, v) Sjk (t, v). (12)
i=0 (j1 ,...,jm ) k=1 k=i+1

These quantities can be efficiently computed using the moment generating

function.

4
3 Copula models
Given the marginal distributions of time to default, the joint distribution may
be constructed using a copula function (see [7] for a detailed exposition). Let
C(u1 , · · · , un ) be a copula function and Fj (tj ) be the marginal cumulative
distributions of default times. Then the joint distribution is given by
¡ ¢
F (t1 , · · · , tm ) = C F1 (t1 ), · · · , Fn (tm ) . (13)

As we mentioned, for BDS pricing two copula models were implemented:

Gaussian and Clayton.

3.1 Gaussian copula

The one factor Gaussian copula is associated with the multivariate normal
random variables that display the correlation structure induced by linear de-
pendence on a single normally distributed factor. This is the most common
copula model used in pricing basket default swaps. It is also used by mar-
ket participants as a convention to quote the BDS prices in terms of the
correlation coefficients.
Let {Xj }mj=1 be a family of m random variables such that
q
Xj = ρj V + 1 − ρ2j Wj , (14)

where V and {Wj }m j=1 are independent standard normal random variables,
and ρ ≡ (ρ1 , · · · , ρm ) is a correlation vector (ρi ∈ [−1, 1]). Then, the Gaus-
sian copula may be defined as

Cρ (u1 , . . . , um ) = P (Φ(X1 ) < u1 , . . . , Φ(Xm ) < um )

Z ∞ Ã !
Φ−1 (u1 ) − ρ1 V Φ−1 (um ) − ρm V
= P W1 < p , . . . , Wm < p φ(v)dv,
−∞ 1 − ρ21 1 − ρ2m
(15)

where Φ and Φ−1 are the normal cumulative distribution function and its
inverse, respectively. A straightforward computation leads to the following

5
equations,
Z Y m µ −1 ¶
Φ (uj ) − ρj v
Cρ (u1 , . . . , um ) = Φ q φ(v)dv, (16)
R j=1 1 − ρ2j
Z Y m µ −1 ¶
Φ (Fj (tj )) − ρj v
F (t1 , . . . , tm ) = Φ q φ(v)dv, (17)
R j=1 1 − ρ2j
Z Y m µ ¶
ρj v − Φ−1 (Fj (tj ))
S(t1 , . . . , tm ) = Φ q φ(v)dv, (18)
R j=1 1 − ρ2j
2
where φ(v) = √1π e−v /2 is the probability density function for the standard
normal random variable V .

3.2 Clayton copula

The Clayton copula belongs to the one-parameter Archimedean family of
copulas.
In general the Archimedean copulas can be introduced as follows. Let V
be a positive random variable with fV (v) the probability distribution func-
tion. Let {Xi }i=1,m be a collection of m random variables such that condi-
tional on V they are independent and
P (Xj < x | V = v) = Gj (x)v , (19)
where {Gj (x)}j=1,m is a set of cumulative distribution functions. Then, the
joint distribution of the {Xi }i=1,m family of random variables is given by,
Z ∞Y
m
F (x1 , . . . , xm ) = Gj (xj )v fV (v)dv
0 j=1
Z ∞ Pm
= evfV (v)dv
j=1 ln Gj (xj )
0
µ Xm ¶
= ψ − ln Gj (xj ) , (20)
j=1

where ψ(s) is the Laplace transform of fv (v), i.e.,

Z ∞
ψ(s) = e−sv fV (v)dv. (21)
0

6
By setting m = 1 in Eq. (20) we get
ln Gj (xj ) = −ψ −1 (Fj (xj )). (22)
Substituting this result in the last equality of Eq. (20), we get the following
expression for the joint cumulative probability of default,
µX
m ¶
−1
F (x1 , · · · , xm ) = ψ ψ (Fj (xj )) . (23)
j=1

Using Eq. (13), we conclude that an Archimedean copula has the following
form,
µX
m ¶
−1
C(u1 , · · · , un ) = ψ ψ (uj ) . (24)
j=1

The Clayton copula is a particular case of Archimedean copula for which

fV (v) is given by the Gamma distribution function, i.e.,
1
v θ −1 e−v
fV (v) = ¡ ¢ , (25)
Γ 1θ
where Γ(x) is the Euler Gamma function. Its Laplace transform, defined in
Eq. (21), is given by,
1
ψ(s) = (1 + s)− θ . (26)
Thus, the Clayton copula can be expressed as,
·X
m ¸−1/θ
−θ
C(u1 , · · · , um ) = uj − m + 1 , (27)
j=1

where we have replaced ψ from Eq. (26) into Eq. (24).

Given the marginal cumulative probability functions of time to default,
{Fi (ti )}i=0,m , the joint cumulative probability can be expressed as
Z ∞Ym
1 −θ
F (t1 , · · · , tm ) = ev(1−Fi (ti ) ) e−v v (1−θ)/θ dv, (28)
Γ(1/θ) 0 i=1

where we have used Eqs. (20) and (26). The joint survival function is given
by
Z ∞Ym
1 −θ
S(t1 , . . . , tm ) = (1 − ev(1−Fi (ti ) ) )e−v v (1−θ)/θ dv. (29)
Γ(1/θ) 0 i=1

7
We mention that while for the Gaussian copula model the dependency is
described by m parameters, i.e. the correlation coefficients ρi , for the Clayton
copula model the dependency is controlled by a single parameter θ.

3.3 Tail dependencies in the copula models

An important characteristic of the joint distribution is captured by the tail
dependency. The tail dependency can be measured mathematically by the
following λL and λU parameters,

C(u, u)
λL = lim P (u2 < u | u1 < u) = lim ,
u→0 u→0 u
1 − 2u + C(u, u)
λU = lim P (u2 > u | u1 > u) = lim .
u→1 u→0 1−u
(30)

Then, for the Clayton copula model, we have

λL = 2−1/θ , (31)
λU = 0, (32)

while for the Gaussian copula model we have

λL = 0, (33)
λU = 0. (34)

These results show that, although both copula models capture the depen-
dency among times to default, the Gaussian copula model fails to describe
any tail dependency.
Figures 1, 2, and 3, 4 show the contour and 3D plots of the joint probabil-
ity distribution function of two normally distributed random variable under
the Gaussian copula model for correlations ρ = 0.15 and ρ = 0.5, respectively.
In both cases the contours are symmetric ellipsoidal curves.
Using the same type of contour and 3D plots, Figs. 5, 6, and 7, 8 show the
joint probability distribution function for the same two normally distributed
random variables using the Clayton copula for θ = 0.365 and θ = 1, respec-
tively. In both cases the contours are elongated in the region where both
random variables take negative values. This is a characteristic signature of

8
the high order dependency for the negative tails of the marginal distribu-
tions. We mention that for positive values the joint probability exhibits a
low level of dependency, similar to the Gaussian copula model.3
We conclude that a BDS pricing model based on the the Clayton copula
infers more dependency for multiple defaults that a model based on the
Gaussian copula can describe.

4 Implied marginal distribution of time to de-

fault
The implied marginal distributions of default times are extracted from the
quoted CDS spreads curves for each individual obligor. We choose a piecewise
exponential function to model the survival function, i.e.,
· µ NX−1 ¶¸
S(t) = exp − λ1 t + λi+1 max(t − Ti , 0) , (35)
i=1

where λi are parameters and Ti are the various CDS times to maturity. Con-
sequently, the marginal cumulative distribution and the probability distribu-
tion function of default times are given by,
· µ N
X −1 ¶¸
F (t) = 1 − exp − λ1 t + λi+1 max(t − Ti , 0) , (36)
i=1
µ N
X −1 ¶ · µ N
X −1 ¶¸
f (t) = λ1 + λi+1 1t≥Ti exp − λ1 t + λi+1 max(t − Ti , 0) ,
i=1 i=1
(37)
respectively. By 1t<T we denote the step function that is equal to 1 for t < T
and to 0 otherwise. The calibration of the λi coefficients to the market CDS
spreads may be performed using a straightforward bootstrap procedure.

5 BDS sensitivity measures

Two sensitivity measures were implemented, the sensitivity to the CDS spreads
and the sensitivity to the interest rates.
3
In fact for both copula models λU = 0.

9
 The sensitivity to the CDS spreads is measured by the “Spread DV01".
The “Spread DV01" is defined as the BDS price variation to a 1 bps parallel
shift of each individual CDS spread curve. In addition we compute an aggre-
gated “Spread DV01" as the BDS price variation to a 1 bps parallel shift of
all the CDS spread curves simultaneously. Note that the aggregate “Spread
DV01" is not the sum of the individual curves “Spread DV01", but it is a
good indicator of a global sensitivity of the BDS price to the CDS spread
curves.
The sensitivity to the interest rates is measure by the “IR DV01". The
“IR DV01" is defined by the BDS price variation to a 1 bps parallel shift of
the risk-free interest rate curve. The parallel shift is performed before the
calibration of the implied marginal distributions of times to default to the
CDS spread curves.

6 Discussions
It is interesting to analyze the BDS spreads behavior as a function of the
basket dependencies, whether the dependency is represented as correlation
in the Gaussian copula case or as θ in the Clayton copula case. We will
demonstrate this behavior in the Gaussian copula model with single correla-
tion. The Clayton case can be treated in a similar fashion.
We consider two baskets of 5 names. For each basket we have computed
the BDS spread for first, second, third, fourth, and fifth to default as a
function of the single (common) correlation factor ρ. The BDS spread is
reported as a percentage of the aggregate sum of the equivalent CDS spreads.
The first basket consists of 5 names of relatively equal creditworthiness.
The results are presented in Fig. 9. We note that, as a function of ρ, the
first to default curve is decreasing, while the higher order default curves
are increasing. This behavior can be explained by the fact that while the
correlation is increasing the basket entities tend to behave similarly. Thus,
the probability to have a first to default event is decreasing as ρ goes to 1
since the other four entities that dominate the basket are not in default. At
the other extreme, the probability of the fifth to default event is increasing
as ρ goes to 1 since all the basket entities will tend to default at the same
time.
A peculiar behavior is presented by the second to default curve that
has a maximum around ρ = 0.9. For ρ < 0.9 the curve is increasing as a

10
result of the increasing probability of a second to default event. For ρ > 0.9
the other three basket entities that are not in default dominate the basket
behavior leading to an overall effect of decreasing the probability of a second
to default event. We mention that the actual ρ value where the curve behavior
is changing depends on the marginal probability of time to default of the
basket entities.
The second basket consist of 4 names of relatively equal creditworthiness
plus the fifth name that is a lot riskier than the others. The results for the
first, second, third, fourth, and fifth to default are presented in Fig. 10. The
overall behavior of the BDS spread curves as a function of the correlation for
this basket is similar to the first basket. However, we note that the first to
default curve is a lot higher than the others. In fact, the first to default curve
is less sensitive to the correlation. This behavior is explained by the fact that
the riskiest basket entity tends to be almost always the first to default.

11
 Gaussian Copula Contours for ρ = .15
3 0.16

0.14
2

0.12
1

0.1
variable 2

0.08

−1
0.06

−2
0.04

−3 0.02
−3 −2 −1 0 1 2 3
variable 1

Figure 1: Contour plot of the joint probability function of two normally

distributed random variables using a Gaussian copula for ρ = 0.15.

12
Figure 2: 3D plot of the joint probability function of two normally distributed
random variables using a Gaussian copula for ρ = 0.15.

13
 Gaussian Copula Contours for ρ = .5
3 0.18

0.16
2

0.14

1
0.12
variable 2

0 0.1

0.08
−1

0.06

−2
0.04

−3 0.02
−3 −2 −1 0 1 2 3
variable 1

Figure 3: Contour plot of the joint probability function of two normally

distributed random variables using a Gaussian copula for ρ = 0.5.

14
Figure 4: 3D plot of the joint probability function of two normally distributed
random variables using a Gaussian copula for ρ = 0.5.

15
 Clayton Copula Contours for θ = .3654 (λ = .15)
L
3 0.16

0.14
2

0.12
1

0.1
variable 2

0.08

−1
0.06

−2
0.04

−3 0.02
−3 −2 −1 0 1 2 3
variable 1

Figure 5: Contour plot of the joint probability function of two normally

distributed random variables using a Clayton copula for θ = 0.365.

16
Figure 6: 3D plot of the joint probability function of two normally distributed
random variables using a Clayton copula for θ = 0.365.

17
 Clayton Copula Contours for θ = 1 (λ = .5)
L
3 0.18

0.16
2

0.14

1
0.12
variable 2

0 0.1

0.08
−1

0.06

−2
0.04

−3 0.02
−3 −2 −1 0 1 2 3
variable 1

Figure 7: Contour plot of the joint probability function of two normally

distributed random variables using a Clayton copula for θ = 0.365.

18
Figure 8: 3D plot of the joint probability function of two normally distributed
random variables using a Clayton copula for θ = 0.365.

19
 1.2
1TD
2TD
3TD
4TD
1 5TD

0.8
Pct of Aggr

0.6

0.4

0.2

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
rho

Figure 9: The BDS spreads for the first, second, third, fourth, and fifth to
default as functions of correlation ρ, for a balanced basket of 5 entities of rel-
ative similar creditworthiness. The basket spread is reported as a percentage
of the aggregated sum of the individual CDS spreads, “Pct of Aggr".

20
 1
1TD
2TD
0.9 3TD
4TD
5TD
0.8

0.7

0.6
Pct of Aggr

0.5

0.4

0.3

0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
rho

Figure 10: The BDS spreads for the first, second, third, fourth, and fifth to
default as functions of correlation ρ, for a unbalanced basket of 5 entities
where four of them are of similar creditworthiness and the fifth entity is a lot
more riskier. The basket spread is reported as a percentage of the aggregated
sum of the individual CDS spreads, “Pct of Aggr".

21
References
[1] Jean-Paul Laurent, Jon Gregory (2003), ”Basket Default Swaps, CDO’s
and Factor Copulas”, working paper.

[2] Philipp J. Schonbucher (2003), ”Credit derivatives pricing models: Mod-

els, Pricing and Implementation”, Wiley.

[3] John Hull and Alan White (2003), ”Valuation of a CDO and an nth to
Default CDS Without Monte Carlo Simulation”, working paper.

[4] Dilip Madan, Michael Konikov, Mircea Marinescu (2004), ”Credit and
Basket Default Swaps”, to be publish.

[5] Christian Bluhm, Ludger Overbeck, Christoph Wagner (2002), ”Credit

Risk Modeling”, Chapman and Hall/CRC.

[6] Wolfgang Breymann, Alexandra Dias, Paul Embrechts (2003), ”Depen-

dence structures for multivariate high-frequency data in finance”, Quan-
titative Finance, 3, 1-14.

[7] Roger B. Nelsen (1998), ”An Introduction to Copula”, Springer.

22